Damages Control

By GREGG POLSKY and DAN MARKEL

WHEN corporations like Exxon, State Farm and Phillip Morris lose tort cases, juries occasionally award, in addition to compensation for the plaintiff’s injuries, extensive punitive damages.

But jurors are often unaware that companies are able to deduct those punitive damages in calculating their federal income taxes, saving them millions of dollars and undermining the original goal of the damages: to punish reprehensible corporate behavior.

The measure is well intentioned. But because most cases are settled before they reach a jury, it won’t work. Fortunately, there’s a better approach.

When plaintiffs and defendants reach a settlement before a trial, which happens in most cases, they aren’t required to specify which parts of the settlement are punitive and which are compensatory; there is typically just one number. That allows defendants to disguise the amounts that they would have paid as punitive damages as additional compensatory damages.

And because the measure maintains the deductible status of compensatory damages, nearly all punitive damages will remain, as a practical matter, deductible. This easy circumvention surely explains the meager revenue projections from the measure: $315 million over 10 years.

While the Internal Revenue Service might try to dissect settlements and classify portions of them as punitive damages, to do so it needs help from both parties to the negotiation. The problem here is that plaintiffs have no incentive to characterize the settlement correctly. Indeed, in cases involving personal physical injury, plaintiffs are better off tax-wise by characterizing the settlement as entirely non-punitive because, while the punitive damages they receive are subject to tax, the compensatory damages are not.

Put a different way, the root of the problem is that jurors tend to believe that punitive damages are not deductible, even though they are. So why not have plaintiffs’ lawyers make jurors aware of the tax deductibility of punitive damages, and teach them how to adjust their awards to offset the deduction’s effect? While plaintiffs’ lawyers don’t do this now, there is no precedent or persuasive legal argument that prevents them from doing so.

Such “tax-aware” juries would probably award higher punitive damages to offset the fact that punitive damages were tax-deductible. But more important, the prospect of tax-aware jurors would also raise the amounts of settlements before trial — when, again, most cases are actually resolved. This is because the amount of a settlement depends on the amount that a jury is expected to award after a trial. If tax-aware juries became the norm, plaintiffs would push for higher settlements, and thus both settling and non-settling defendants would bear the correct amount of punishment. Under the Senate’s approach, in contrast, only the very few non-settling defendants would bear that punishment.

The tax-awareness approach is by no means perfect. It requires juries to determine yet another fact during punitive-damages proceedings, namely the defendant’s marginal tax rate. It also increases the sizes of recoveries to punitive-damage plaintiffs and their lawyers, which is either a good or a bad thing, depending on your perspective. Nevertheless, given the practical futility of the Senate measure, tax-awareness is a far better approach to solving the problem of under-punishment.

There is a good chance that the Senate measure will become law, if only because the public is exasperated by the BP fiasco and Congress desperately needs revenue, even a relatively small amount. But if it does, it will be yet another example of expedient politics trumping sound policy.

Gregg Polsky and Dan Markel are, respectively, law professors at the University of North Carolina at Chapel Hill and Florida State University.